How We Think About Emergency Funds

June 20, 2018 BY Mark Haser

Most clients come to us having heard the adage of keeping three to six months’ worth of expenses in cash as an emergency fund. For affluent families, this rule of thumb can mean sidelining well over $100,000. While it can be comforting to know you have plenty of money to cover the unexpected, doing so comes with theopportunity cost of missing out on significant investment earningsover time. And unless you are woefully underinsured, there are relatively few emergencies that require an immediate six-figure payment, which is why we often tell our clients it doesn’t make sense to maintain such a large amount of cash. Read on to learn some of the strategies we recommend for reducing your emergency fund and why you may not need one at all.

Although an emergency fund is based upon your expenses, it is also a function of your income and savings rate. The higher your savings rate (think monthly income minus expenses), the less of an emergency fund you need since you will likely be able to cover most unexpected expenses out of your regular monthly savings. Similarly, the more stable and diversified your incomes sources, the less of a need you will have for a six-month emergency fund. If you have a sizable savings rate, a job that is reasonably stable, and/or you’re part of a two-income household, then you may opt for an emergency fund that covers just a month or two of non-discretionary expenses. If you are part of a single-income household but would receive severance in the event of a layoff, you can take your severance package into account when developing your emergency fund strategy.

Another reason for reducing the size of your cash emergency fund is if you have taxable investments balanced between equities and fixed income. In this case you can always cash in some of your fixed income holdings. Given that the preponderance of fixed income returns come in the form of coupon payments, capital gains (or losses) are generally a minor concern; and the larger your portfolio, the smaller impact this will have. We do this for clients on occasion, and it enables them to keep more of their money invested earning the higher fixed income yields. This may not work as well for individuals or families who invest entirely in qualified savings buckets (e.g., 401k’s and 529 plans) and don’t have taxable investment sources they can tap into during an emergency.

Remember, the purpose of an emergency fund is to provide immediate liquidity rather than needing to sell off longer-term investments that may incur fees, hefty taxes, or an unfavorable price. Credit cards are another effective tool you can use to fulfill this need in the short-term. For example, your roof starts to leak and requires a $15,000 repair, but you only keep $10,000 of cash on hand. You can put a portion on the credit card until your next paycheck arrives and then pay off your credit card in full before the next statement cycle. In doing so, you are effectively taking an interest-free loan from your credit card. This works well and allows you to maintain a smaller emergency fund provided you have a high savings rate and the discipline to pay off the credit card before incurring any interest charges!

If you’re really keen on minimizing the “cash drag” that an emergency fund has on your investment portfolio, then you may also want to consider setting up a home equity line of credit (HELOC) as a complement to, or perhaps in lieu of, keeping an emergency fund. A HELOC is a line of credit secured by the equity in your home. You can setup a HELOC quickly and with little to no upfront costs, and you typically access it through check writing. Most importantly, if you don’t use the HELOC, you pay no interest charges. The major disadvantage of a HELOC is that it comes with a variable interest rate tied to the prime rate (plus/minus a margin), so you do need to be cautious of rising interest rates in the event you utilize the HELOC and can’t quickly pay it off. In short, a HELOC can function as an emergency fund, but with the added benefit of you not needing to hold any excess cash. This can boost investment returns over the long run as you are able to fully invest your money in the market.

However much money you elect to set aside in the event of an emergency, we recommend you keep it separate from your normal, day-to-day spending money. You shouldn’t allow your emergency fund to commingle with the funds in your checking account as you’ll be at a much higher risk of spending the money on a non-emergency, whether accidentally or intentionally! To help you psychologically separate your emergency fund from the rest of your cash, try setting up a separate savings account. Many FDIC insured savings accounts are now paying north of 1.60%, and we know of one New England-based bank paying 2% for the first 12 months.

Conclusion

From an investment perspective, cash, while highly safe and liquid, is a drag on your performance over the long-run. If you’re someone who has always kept six months of expenses in a savings account, ask yourself if you really need that large of an emergency fund and how you might be able to better deploy your money. If your financial situation is stable and you’re part of two-income household, you can very likely finance most emergencies in conjunction with your credit cards or by using your HELOC credit line.

Questions about how to structure your emergency fund? Give us a call or send us an email and we’d be happy to chat!